Darrell Duffie

In the increasingly vital yet bewildering world of financialeconomics, Darrell Duffie is both a deep-level theorist anda hands-on plumber. He marries abstruse theory with solidreality and, unlike most economists, can then lucidly explainthis often awkward union to those without his intuitive grasp.Few are better suited, then, to evaluate and clarify keychallenges in the aftermath of the recent financial crisis.Duffie can’t eliminate the fog, of course, but his insightsare among the sharpest.

Over two decades at Stanford’s Graduate School of Business,he has studied financial institutions and their networks,securities pricing, credit markets and risk management.This research is not light reading. He generates inscrutablepapers on “ergodic Markov equilibria,” for example, and wasanalyzing tri-party repos and credit default swaps before mosteconomists knew they existed.

Fortunately, he also writes for the rest of us. Since the crisis,he has authored scores of commentaries and policy papers,testified before Congress and regulatory agencies, and writtenbooks that—in accessible language—illuminate murkyfinancial markets and dissect systemic failure. The highestvalue of this “popular” work may be that after clarifying theweaknesses of existing practices or proposed policy, he thensets out better solutions that suddenly seem obvious.

In the June Region, Duffie guides us through the hotlydebated Volcker rule, into the fragility of repo markets andthe growing importance of central clearing counterparties,and then on to the mysteries of asset pricing. In the end,we’re left with the uncanny (if inaccurate) sense that weactually see things as clearly as he does.

Photographs by Peter Tenzer

13 JUNE 2012

IMPLEMENTINGTHE VOLCKER RULE

Region: Perhaps we can begin with theso-called Volcker rule, which would pro-hibit banks from engaging in proprietarytrading.* It seems to be among the mostcontroversial parts of Dodd-Frank.

Earlier this year, you presented at theSecurities and Exchange Commission(SEC), expressing concerns about theimplementation rules being drafted byregulators, including the Fed, for theVolcker rule. Specifically, you highlight-ed the degree to which those proposedrules would reduce the market-makingcapacity of banks and that the void thuscreated might then be filled by the shad-ow banking sector, with potentiallyadverse consequences.

Would you briefly explain your con-cerns? And perhaps tell us why the coststhat you envision might outweigh thebenefits that Paul Volcker, the Fed andothers foresee.

Duffie: Let’s go back to the intent of thestatute that Paul Volcker had in mind.As I take it, it’s a good intent, which is tolower the risk of failure of banks becausethey are systemically important and

because we do subsidize the depositinsurance system. We wouldn’t want toencourage risk taking by banks tobecome unsafe. So the statute starts bysaying, OK, let’s therefore remove somerisky trading that the bank does on itsown account, but let’s not remove anumber of things, the two most notableof which are underwriting, which wasnot my main subject, and market mak-ing, which was my main subject.

Region: What is “market making”?

Duffie: Market making is providingimmediacy to investors. That is, whensomeone wants to buy quickly, you sellto them if you’re a market maker. Ifsomeone wants to sell immediately, youbuy from them if you’re a market maker.And that provision of immediacy isdone for an expected return that’sdesigned to compensate the marketmaker for bearing the risk of changingits inventory to meet the demands ofthose investors.

So we have the statute, and nowwe’re in a period, as you know, wherethe agencies, including the Fed, arecharged with implementing the statutewith rules: rule writing. That processhas been delayed out of concern thatthe implementation the agencies haveproposed might have unintended con-sequences. There were 17,000 publicsubmissions on this—way more thanany other rule-writing submissionprocess.

Now, most of those are crank letters,but probably a few hundred or so areserious submissions. Some of them are

saying, “Pour it on. We do want to keeprisky trading of all sorts out of thebanks, and let’s not make any allowancesunless absolutely needed.”

Other submissions, I would say prob-ably a large number of them, are fromthose like me who feel that this willharm the liquidity of markets becausemarket making will be unintentionallyconstrained by the proposed rules in amanner I’ll describe in a minute.

As I also indicated in my submission,if the proposed implementation is adopt-ed and once that void in market liquidi-ty has eventually been filled, we’ll haverobust market making, but not withinthe regulated banking system. Thatleaves some concerns about financialstability. We didn’t have a very happyexperience with large nonbank marketmakers and other investment banksgoing into the financial crisis. Part ofthat experience was due to the fact thatthese firms weren’t well regulated, evenrelative to banks. You could argue aboutthe quality of regulation of banks, but Iwould say the majority view is that theinvestment banks, which at the timewere not banks, were much more poor-ly regulated for capital liquidity and risktaking.

Now that might not happen. Because ofthe Dodd-Frank Act, we now have theFinancial Stability Oversight Council, andit’s charged with supervising the risk takingof large nonbanks. And we do have aregime of capital and liquidity require-ments for broker-dealers. Some of thismarket making that would come out of thebanks could go into broker-dealers, whichwould then be supervised by the SEC.

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This will harm the liquidity of markets because market making will beunintentionally constrained by the proposed rules. Once that void in marketliquidity has eventually been filled, we’ll have robust market making, butnot within the regulated banking system. That leaves some concerns aboutfinancial stability. … I don’t think we want to run that experiment.

*Terms highlighted in blue are defined in a glossary on pages 26-27.

But I am concerned about that. TheSEC doesn’t have a great track record inthat area. The capital and liquidityrequirements are not under the Basel IIIprocess. They might adopt capital andliquidity requirements of that type, butthey might not. And there is much morelimited access to a lender of last resortfrom the central bank once you’re out-side of the regulated banking environ-ment. There are some subtleties here,like Section 23A of the Federal ReserveAct, but I won’t go into that here.

Overall, I am concerned about wherewe might end up. We might actually endup better than we are today; we mightnot. I don’t think we want to run thatexperiment to find out.

Coming back to one part of yourquestion, what is it about the proposedrules that might reduce market makingin the banks and cause it to appearsomewhere else? As you probably know,there’s an approach in the proposedimplementation of the Volcker rule thatis based on metrics. The metrics them-selves are not really the main issue. Theyraise costs for compliance and difficul-ties like that, which are not my mainconcern. The key issue is: How mightthose metrics be applied? In the propos-al document, the agencies, including theFed, are very cautious to say that theyare not setting trip wires for these met-rics. At this point, they are solicitingcomments about how to use the metrics.They also say, however, that market-making profits should come primarilyfrom bid-ask spreads, fees and commis-sions, and not from price appreciation

of the asset that’s being taken on oroffloaded by the market maker.

Whereas, in fact, if you look at thecommon practice of market making, itdoes include a substantial amount of risktaking that involves the market makerbuying low and selling high later on inthe market in order to profit fromexpected price appreciation. That’s one ofthe ways that the market maker is com-pensated for taking large chunks of risk.

Region: But is that proprietary trading?

Duffie: Indeed it is. Market making is aform of proprietary trading thatCongress decided to exempt from itsproprietary trading prohibition.

The other aspect of the proposal doc-ument suggesting that this kind ofrobust provision of immediacy by mar-ket makers would not be permitted islanguage to the effect that sudden, dra-matic, unpredictable increases in riskwould be an indication of trading that isnot market making.

In fact, while a lot of market making isof the small-risk flow trading type, thereare also many cases in which an investorwants to offload unpredictably a largeamount of risk and will call a market

maker to absorb that risk. That would runafoul of the Volcker rule if the agenciesapplied their metrics with that philosophy.And banks would set up their internalcompliance engines to rule out thoseforms of trading in order to not get dingedby a regulator and have their firms’ namesin the headlines. They will allocate lesscapital to taking these kinds of risky mar-ket-making trades, and then others willsee the opportunity to fill that gap.

As Paul Volcker has predicted, and Ithink he’s right, it’s not that we will haveilliquid markets forever. Within five, 10or 15 years, others will come in and, as Isaid, that will introduce other unintend-ed consequences.

REFORM OF MONEY MARKETS

Region: After you gave your presenta-tion on the Volcker rule, you wereaccused by some of favoring the finan-cial industry. But it seems you’ve actual-ly incurred the industry’s disfavor withyour ideas on reforming money marketmutual funds—and for that matter, Ithink also with your recommendationthat foreign exchange derivatives not beexempted from the Dodd-Frank swapsrequirements.

15 JUNE 2012

Loss buffers and conversion to a variable net asset value were thetwo alternate proposals that the Squam Lake Group suggested.A third proposal is a redemption gate: If you have $100 million investedin a money market fund, you may take out only, say, $95 million at one go.There will be a holdback. …These three main ideas are floating around.I feel sympathy for the Securities and Exchange Commission. It has a toughdecision to make.

Could you explain your concernsabout these mutual funds, beginningwith the role they played in the recentfinancial crisis? How do you proposethey be reformed to prevent those risksin the future?

Duffie: As you know, these funds aretreated essentially as cash investmentsby many investors, both retail and insti-tutional. They are backed by short-termassets like commercial paper and repur-chase agreements, which we might talkabout later. When there are any con-cerns about the backing for thosemoney market funds, investors havedemonstrated, particularly after the fail-ure of Lehman when one of thesemoney market funds lost money …

Region: The Reserve Fund.

Duffie: Yes, the Reserve Primary Fund.The institutional investors demonstrat-ed that they have very twitchy fingersand will leave almost instantly. And theyleft not only that money market fund,but the entire prime money market fundcomplex. Institutional investors tookout roughly 40 percent of their holdingsin prime funds in the order of twoweeks.

Region: Which was roughly how muchmoney?

Duffie: About $300 billion to $400 bil-lion. And that would have continued tothe point of ultimate meltdown of thecore of our financial system had theTreasury not stepped in to guaranteethose money market funds. In amoment, we’ll talk about the contagioneffect of that meltdown. But just stickingto money market funds for now, econo-mists such as myself who are concernedabout this want to encourage the designof these funds so that they are not soprone to flight by institutional investors.

A few ways to do that have been pro-posed and are now being considered bythe Securities and Exchange Commission,

which is the primary regulator for moneymarket funds. One of those proposals is toput some backing behind the money mar-ket funds so that a claim to a one-dollarshare isn’t backed only by one dollar’sworth of assets; it’s backed by a dollar anda few pennies per share, or something likethat. So, if those assets were to decline invalue, there would still be a cushion, andthere wouldn’t be such a rush to redeemshares because it would be unlikely thatcushion would be depleted. That’s one wayto treat this problem.

A second way to reduce this problem isto stop using a book accounting valuationof the fund assets that allows these sharesto trade at one dollar apiece even if themarket value of the assets is less than that.

Region: Instead, mark to market?

Duffie: Yes, mark to market. That’s calleda variable net asset value approach,which has gotten additional supportrecently. Some participants in theindustry who had previously said that avariable net asset value is a completenonstarter have now said we could dealwith that.

Region: You and the Squam Lake Groupproposed that in a working paper, Ibelieve.

Duffie: Right. Those two measures that Ijust described, loss buffers and conver-sion to a variable net asset value, werethe two alternate proposals that theSquam Lake Group, of which I’m amember, suggested back in January2011. [See Baily et al. 2011.] We made asubmission to the SEC on its proposedtreatment of money market funds.

A third proposal, which has sincecome to the fore, is a redemption gate: Ifyou have $100 million invested in amoney market fund, you may take outonly, say, $95 million at one go. Therewill be a holdback. If you have redeemedshares during a period of days beforethere are losses to the fund’s assets, thelosses could be taken out of your hold-

back. That would give you some pausebefore trying to be the first out of thegate. In any case, it would make it hard-er for the money market fund to crashand fail from a liquidity run.

Region: The analogy for a pre-FDIC[Federal Deposit Insurance Corp.] bankrun would be the bank temporarilylocking its doors.

Duffie: Instead of a bank holiday, itwould be like a partial bank holiday. Youcan take out only 95 percent of yourdeposits, rather than 100 percent. Thathas the effect of a buffer because eachinvestor in the money market fund isbuffering his own or her own invest-ment with the holdback. And that hasgotten some support as well.

So now these three main ideas arefloating around. The SEC has a seriousissue about which of these, if any, toadopt. And it’s getting some push-backnot only from the industry, but evenfrom some commissioners of the SEC.They are concerned—and I agree withthem—that these measures might makemoney market funds sufficiently unat-tractive to investors that those investorswould stop using them and use some-thing else. That alternative might be bet-ter or might be worse; we don’t know. It’san experiment that some are concernedwe should not run. And, of course, thosethat sponsor money market funds woulddefinitely not like to run that experiment.

I still believe that the Squam Lakeproposals are good. But I think we alsoneed to be aware that the money mar-ket fund industry could shrink signif-icantly as a result of any of these pro-posals. We need to monitor where thatliquidity next shows up. Because if itshows up, for example, in ordinarydemand deposits in a bank, well, thoseare insured but only up to a minusculeamount relative to the investments oflarge institutional investors; $250,000is essentially nothing for a Pimco or aBlackRock or any large institutionalinvestor.

16JUNE 2012

So if a bank were to become of ques-tionable solvency or liquidity, we couldagain see some run effects. Unsecureddeposits are not backed by anything spe-cific, as opposed to money market funds,which are backed by specific assets. So itis a difficult issue. I feel sympathy for theSEC. It has a tough decision to make.

REFORMING REPO MARKETS

Region: As you know better than most,repos, or repurchase agreements, havebecome the main means for providingliquidity in the money market mutualfunds. During the crisis, the repo mar-ket failed in a major way and policy-makers called for a significant reform ofrepo market infrastructure.

You’ve studied tri-party repo marketsin particular and worked with the NewYork Fed in developing proposedchanges to its infrastructure. Can youtell us why reform is needed in tri-partyrepo and why you consider automationso critical? And secondly, in your view,why did the private industry task forceassigned responsibility for reform fail,such that the New York Fed felt it neces-sary to take the reins?

Duffie: That’s a great question. Let’s startwith a description of what tri-party repois. This concerns, basically, money mar-ket funds, which we just discussed—andother cash investors—that lend money

over very short terms, like one night, tolarge banks like JPMorgan, GoldmanSachs, Morgan Stanley and so on.

Region: What types of collateral are usedto secure these loans?

Duffie: The large dealer banks securethese overnight loans with securities,typically Treasuries, agencies, corporatebonds and so on. Right now, the major-ity of it is Treasuries and agencies. Let’sstart with the legacy system, and thenwe’ll talk about the makeover that hasbegun. Under the old system, theseovernight loans would mature in themorning. The cash investors would begiven back their cash plus interest, andthe dealer banks would be given backtheir collateralizing securities.

But the dealer banks needed intradayfinancing for those securities. That is,between the morning and the afternoonwhen the next repurchase agreementsare arranged, somebody had to financethose securities, and that was done bythe tri-party clearing banks. Theseclearing banks also assist with thearrangement of the repo deals betweenthe dealers and the cash investors.

Region: And there are effectively justtwo of them.

Duffie: Right, two: JPMorgan Chase andBank of New York Mellon handle essen-

tially all U.S. tri-party deals. As part ofthis, they provide the credit to the dealerbanks during the day. Toward the end ofthe day, a game of musical chairs wouldtake place over which securities wouldbe allocated as collateral to new repur-chase agreements for the next day. All ofthose collateral allocations would get setup and then, at the end of the day, theswitch would be hit and we’d have a newset of overnight repurchase agreements.The next day, the process would repeat.

This was not satisfactory, as revealedduring the financial crisis when two ofthe large dealer banks, Bear Stearns andLehman, were having difficulty con-vincing cash investors to line up andlend more money each successive day.The clearing banks became more riskaverse about offering intraday credit.

We have to be a bit cautious here. Ihave a conflict of interest that I need todisclose. I’m a consultant to Lehman ina matter that is related to these issues.I’m under a nondisclosure agreement.Of course, I won’t disclose anything herein violation of that agreement.

In any case, the clearing banks got toa point at which they might not agree toprovide intraday credit to these banks.And if they had provided it, there was anunlikely but consequential event in

17 JUNE 2012

The dealer banks needed intraday financing for those securities.That was done by the tri-party clearing banks. … If the securitieswere of questionable value or if the leverage at the clearingbanks became too large, absorbing all of that might become anissue. Maybe they would say, “No, we won’t offer youintraday loans.” That could immediately snuff outone of these dealer banks … absent emergencylender-of-last-resort treatment by the Fed.

which they did provide credit and thedealer would fail during the day. Theclearing bank would be left on the hookto deal with all of the collateral. Thatshould normally not be fatal, because thecollateral was there to back the loan. Butthe amounts of these intraday loans fromthe clearing banks at that time exceeded$200 billion apiece for some of thesedealers. Now they’re still over $100 bil-lion apiece. That’s a lot of money.

Region: Potentially unsecured.

Duffie: Well, it is secured, by securities.But if the securities, some of them,were of questionable value or if theleverage at the clearing banks becametoo large, absorbing all of that collater-al onto their balance sheets mightbecome an issue for them. Maybe theywould say, “No, we won’t offer youintraday loans.” That could immediate-ly snuff out one of these dealer banksbecause there’s no way they could sur-vive if they couldn’t finance their secu-rities for the next day. For operationalreasons, a dealer cannot switch to anew clearing bank on short notice.Absent emergency lender-of-last-resorttreatment by the Fed, this would basi-

cally be the end of whatever dealerbank was on the wrong end of this.

Lehman’s portfolio of repurchaseagreements was shrinking dramaticallythrough that period as it tried to unwindits positions because of concerns overwhether it could, in fact, finance them.Lehman did go bankrupt, as we allknow. Lehman’s broker-dealer sub-sidiary kept running for another fewdays, relying heavily on the Fed forfinancing of its securities.

AUTOMATING CLEARANCE

Region: In your proposal on reform of tri-party repo infrastructure, you and yourco-authors emphasize the need for auto-mated clearance. How would that help?

Duffie: One way the system would runbetter is if the tri-party banks were ableto pass the baton from one cash lender toanother cash lender without ever beinginvolved as a creditor themselves. Thatcan be done. It’s essentially what’s beingdone in Europe, with minor exceptions.

But doing that or even getting closeto that requires very slick operationalcapability, including very good informa-tion technology. And it requires enough

trust by dealers that the available tech-nology will allocate collateral efficientlyto the various loans, so that the dealerswill stand back and just allow the infor-mation technology to take over andautomatically allocate collateral out ofthe maturing repurchase agreementsand into the new repurchase agreementswithout the clearing bank having to pro-vide interim credit.

Region: So it speeds the process, and italso removes discretion.

Duffie: It removes discretion in a num-ber of ways. It removes the discretion ofthe dealer who might not trust the effi-ciency of the information technologyand wants to interfere in the process bysaying, “No, no, we didn’t want thosesecurities into those loans. We wantedthem into these loans because that’smore efficient.” If the information tech-nology is very good, trustworthy androbust, they could just stand back andlet that happen.

Moreover, the dealers might say, “Look,we also want the ability to quickly extractsome particular Treasuries or agenciesthat a customer would like to buy. We’dlike the ability to extract those from thepool of collateral backing some loans andreplace them easily with other stuff.”

You need good information technol-ogy to handle all of that efficiently. Thissort of technology exists right now, butit’s basically legacy technology. Imaginebaling wire, Scotch tape and staples. It’sgoing OK but it’s not gotten to the pointwhere the New York Fed as the primaryregulator of this repurchase agreementmarket is satisfied that it’s robust to thedefault of a dealer. Therefore, the NewYork Fed, in effect, pulled the plug onthe industry project because it was goingtoo slowly toward a satisfactory removalof the clearing banks from the creditprovision in this market.

Region: You’ve pointed out thatEuropean tri-party repo is more effi-cient, more automated. I can’t believe

18JUNE 2012

One way the system would runbetter is if the tri-party bankswere able to pass the baton fromone cash lender to another cashlender without ever being involvedas a creditor themselves. Butdoing that or even getting closeto that requires very slick opera-tional capability, including verygood information technology.… Right now, it’s basicallylegacy technology. Imaginebaling wire, Scotch tapeand staples.

their technology is that much better. Istheir market smaller?

Duffie: In fact, their technology is some-what better because they started later.When the eurozone came into being in2001, they had the advantage of not hav-ing legacy technology because there wasno legacy eurozone. They invested invery good infrastructure and good tech-nology. And they have the advantageyou just described of having a smallermarket.

Region: Can you give a sense of the rela-tive scale?

Duffie: Well, in Europe, the banks do alot of the financing of European corpo-rations directly with bank loans.Securities are used less. Moreover, inEurope, securities are often held onbank balance sheets with generalfinancing, rather than on broker-dealerbalance sheets, where the cheapestfinancing is through repo. The corpo-rate bond market in total is much small-er, perhaps about half the size. At theend of 2010, the European tri-partyrepo market was only about one-fourththe size of the U.S. market, based ondata from the International CapitalMarket Association.

EUROZONE

Region: What is your sense of the funda-mental problems in the eurozone? It’snot repro markets, since apparentlythey’re better than ours. It’s not creditdefault swap speculation—you’ve saidelsewhere that that’s not really the issuein Greece. But what then would you pro-pose to solve the fundamental problemsin the eurozone? I think you said recent-ly that Europe will “muddle through.”That’s pretty tempered optimism.

Duffie: Yes, I’m afraid that a good sce-nario, looking forward from this point,is that over time they’re able to recapital-ize their banking system and to put some

firewalls around peripheral sovereigndefaults, so they will have time to even-tually restructure the eurozone itself.

The recent eurozone banking andsovereign credit crises are partly symp-tomatic of the very structure of the euro-zone that was baked in at the turn of thecentury, when it was agreed to have amonetary union but not a fiscal union.

Comparisons are made with theUnited States, whose states also have amonetary union but not a fiscal union.These are not apt comparisons. TheseEuropean countries are sovereigns; theyare not constitutionally required to bal-ance budgets. They rely on the euro as acommon currency, but can be overlyreliant on the cheap financing availablethrough a stable, large currency zoneand can get themselves into trouble.And some of them have done that.

Now there’s a damned-if-you-do anddamned-if-you-don’t problem. The larg-er, wealthier countries such as Germanyand the Netherlands are in a positionwhere they are able to forestall the deep-est crises caused by banking problemsand peripheral country defaults by put-ting more of their capital into play. Thatmay simply discourage weaker sover-eigns from taking care of their own fiscalproblems and kick the can down theroad. They may have to do it again.

On the other hand, if they don’t con-tribute significant capital to stop theseshort-term banking and sovereigndefaults from occurring, at least disrup-tively, then Europe could be thrown intoa very significant financial crisis andassociated deep recession.

So the “muddle through” scenario issome of this and some of that. Each timethe richer European countries give up a

little bit more capital, they demand a bitmore financial discipline. It’s going to bea long, hard road. There are no simplefixes to this.

I would agree with [HarvardUniversity’s] Ken Rogoff, for example,on the deeper structural problems thatthey’re facing. They’ll eventually come, Ithink, toward a fiscal union of somesort, possibly with some departingmembers or at least some taking “sab-baticals.” I think Ken used that term.

Eventually, they’ll probably get some-thing closer to what they want. But inthe meantime, this is harming theirgrowth because the banking system isnot vibrant enough to provide a lot ofcredit, and investors are scared aboutputting much money at risk right now,with the uncertainty about the eurozone.

Region: It’s either short-term pain orlong-term pain.

Duffie: Yes, “muddle through.” If theycan manage to do that, that’s good news.What we don’t want is a sudden bankingcrisis, which I was worried about lastfall until these giant LTROs [long-termrefinancing operations] came out of theECB. I’m referring to long-term refi-nancing operations by which theEuropean Central Bank, in two roundsnow, has provided close to a trillioneuros of liquidity to banks, secured by avery wide range of collateral for threeyears. The terms are very generous tothe banks.

Despite the headlines these days,Greece is not going to be a big problemfor Europe. In fits and starts, [Greece is]going to default again; I think that’spretty certain. But [it’s] not going to

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The tri-party clearing banks are highly connected, and we simply could notsurvive the failure of probably either of those two large clearing bankswithout an extreme dislocation in financial markets, with consequentialmacroeconomic losses. That’s not a good situation. We should try toarrange for these tri-party clearing services to be provided by a dedicatedutility, a regulated monopoly.

cause the rest of Europe a deep, financialcrisis in itself. The precedents that arebeing set, though, for Greece are impor-tant when handling other countries thatcould get into trouble in the future.

THE ROOTS OF SYSTEMIC RISK

Region: Perhaps now we could discussthe roots of systemic risk in financialmarkets. Many analysts of the crisis haveemphasized interconnectedness. Andcertainly that’s embodied in Dodd-Frank, that interconnections among sys-temically important financial institu-tions need to be addressed in order tomitigate future systemic risk.

But a number of observers like PeterWallison of the American EnterpriseInstitute and John Cochrane at theUniversity of Chicago have argued thatthe interconnectedness theory is flawed.They suggest that it’s really a “commonshock” to the system that causes sys-temwide stress: that a decrease in anasset that’s widely held, like real estate, iswhat led to the crisis.

You’ve done a great deal of researchon correlated default, information trans-mission in financial markets, liquidity inrepo and other markets, the mechanicsof bank failure. Do you tend to leantoward the interconnectedness perspec-tive or the common shock theory?

Duffie: John and Peter are both goodfriends. I think there are elements oftheir view that are correct. That is, therewere relatively few instances in this cri-sis in which investor B defaulted becausethey didn’t get paid back by investor A.

Nevertheless, there is a substantialamount of connectedness in financialmarkets through such things as thepotential for a fire sale. So if a bank failsand needs to sell its securities in a hurry,the prices of those will likely go down:That could cause a contagion effect forother owners of the same assets.

Then there are forms of interconnect-edness that didn’t actually result indominoes during the crisis because of

government interventions. For example,when AIG was on death’s door, a num-ber of very large banks were exposed toAIG on credit derivatives and wouldhave been stressed considerably had itnot been for the action of the govern-ment to, in effect, bail out AIG.

Similarly, as we discussed a fewminutes ago, money market fundswere in the process of melting down.Let’s trace through what would havehappened had the Treasury not guar-anteed those funds. Without thatintervention, it’s conceivable—in fact,I would say even likely—that moneymarket funds would have withdrawnfinancing so rapidly from the dealerbanks through the tri-party repo mar-ket that the survival of some dealerswould have been under exceptionalpressure. That’s because, unfortunate-ly, they were overly reliant on short-term loans obtained from money mar-ket funds through the repurchaseagreement market.

That is a form of connectedness thatdoesn’t sound exactly like the dominostory but does need to be addressed, inmy view.

And that’s only one example. Thereare others. For example, central clearing

counterparties [CCPs] are now going tobe a big part of our new financial sys-tem. They are very connected to somelarge market participants.

The tri-party clearing banks arehighly connected, and we simply couldnot survive the failure of probablyeither of those two large clearing bankswithout an extreme dislocation infinancial markets, with consequentialmacroeconomic losses.

So if you take, for example, the Bankof New York Mellon, it really is too inter-connected to fail, at the moment. Andthat’s not a good situation. We should tryto arrange for these tri-party clearingservices to be provided by a dedicatedutility, a regulated monopoly, with a reg-ulated rate of return that’s high enoughto allow them to invest in the automationthat I described earlier. A dedicated util-ity would not have much moral hazard.It would not have the legal scope forinvesting in other kinds of risky things,only doing tri-party repo—in light of theinterconnectedness problem.

FINANCIAL PLUMBING

Region: This leads to the paper you havedrafted for the Fed’s conference later

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We’re looking at years of work toimprove the plumbing, the infra-structure. … If not well designed,the plumbing can get broken in anykind of financial crisis if the shocksare big enough. Then the financialsystem will no longer function as

it’s supposed to, and we’llhave recession orpossibly worse.

this month. [See Duffie 2012.] You mention in that paper that some

progress has been made, especially interms of capital and liquidity require-ments for regulated banks. But you alsosay that much needs to be done toaddress the plumbing of the financialinfrastructure.

Then you cite six things, some ofwhich we just discussed. They rangefrom broadening access to liquidity inemergencies to lender-of-last-resortfacilities, to engaging in a “deep forensicanalysis” of prime brokerage weaknessduring the Lehman collapse.

And then you touch upon tri-partyrepo markets, wholesale lenders thatmight gain prominence if money marketfunds are reformed and therefore shrink,pursuing cross-jurisdictional supervisionof CCPs and developing plans for theirfailure, and including foreign exchangederivatives in swap requirements.

It’s a daunting amount of work. Eachone of those is a major effort.

Duffie: Yes, it’s a big project.

Region: Indeed, and we haven’t even got-ten the Volcker rule implemented yet—that’ll be a while—let alone, tri-partymarket reform. Well, could you tell usthe key principles that underlie theseefforts, given what you said about sys-temic risk and its sources?

A fundamental objective seems to bea desire to design and regulate majorparts of the infrastructure that, as youput it, are too important to fail.Regulated utilities, for example.

Duffie: Correct. And there has been a lotof progress made, but I do feel that we’relooking at years of work to improve theplumbing, the infrastructure. And whatI mean by that are institutional featuresof how our financial markets work thatcan’t be adjusted in the short run by dis-cretionary behavior. They’re just thereor they’re not. It’s a pipe that exists or it’sa pipe that’s not there. And if those pipesare too small or too fragile and therefore

break, the ability of the financial systemto serve its function in the macroecono-my—to provide ultimate borrowerswith cash from ultimate lenders, totransfer risk through the financial sys-tem from those least equipped to bear itto those most equipped to bear it, to getcapital to corporations—those basicfunctions which allow and promoteeconomic growth could be harmed ifthat plumbing is broken.

If not well designed, the plumbingcan get broken in any kind of financialcrisis if the shocks are big enough. Itdoesn’t matter if it’s a subprime mort-gage crisis or a eurozone sovereign debtcrisis. If you get a big pulse of risk thathas to go through the financial systemand it can’t make it through one of thesepipes or valves without breaking it, thenthe financial system will no longer func-tion as it’s supposed to and we’ll haverecession or possibly worse.

None of these risks that you deftlysummarized is likely to occur in the nextfew years, but we shouldn’t hesitate, inmy view, to invest in a safer and sounderfinancial system, with the thought inmind that some time in the next 10, 20,30 or 40 years, we could have anothermajor financial crisis. Or, that by invest-ing in this manner, we can forestall someof those financial crises. Preparedness isimportant. The cost/benefit analysis,while difficult to do, would probablybear out those recommendations.

MEASURING SYSTEMIC RISK

Region: You have also proposed a verypragmatic, plumbing sort of strategy formeasuring systemic risk: the 10×10×10proposal. Would you summarize thatfor us?

Duffie: Sure. Again, the philosophy isthat our financial system is an intercon-nected system of financial entities,whether they’re market utilities or deal-er banks or large investors, hedge fundsand the like. Until the last few years, ourprimary approach to monitoring the

quality of our financial system insofaras safety and soundness, has been tolook at each of the players in the systemand analyze whether they’re robustenough—especially if they’re systemi-cally important—to withstand thekinds of shocks to which they might besubjected.

I think we have gotten to the point atwhich we need to now consider not justthe nodes in the network, but the linksthat connect them, and to begin tomonitor the financial system as thoughit’s a network. In my proposal, we wouldhave the most systemically importantfirms report to their regulator theirexposures to a range of shocks not onlyto themselves (for example, what woulda 50 percent reduction in the value ofthe stock market do to their balancesheet), but also how much gain or lossthey would experience relative to eachof their largest counterparties for thatshock.

So I call this “10×10×10” (not that 10is necessarily the right number) becausethere would be, let’s say, 10 large, sys-temically important reporting firms,and for each of, let’s say, 10 crisis scenar-ios, they would report their own gain orloss and their gain or loss relative toeach of their 10 largest counterpartiesfor that shock.

They might not be the same counter-parties for one shock as for another.And some of those counterparties

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“How much is enough?” The capitalrequirements of large banks goinginto the last financial crisis weregenerally not enough. I think eventhe banks would agree. … So“more” is an easier answer thancoming up with an exact figure.I would err on the safe side. … Thecost of getting it too high is less, inmy view, than the cost of getting ittoo low.

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might not be among the 10 systemicallyimportant firms. They could be hedgefunds outside of the reporting system orinsurance companies or sovereigns orquasi-sovereigns.

By monitoring those links, we willunderstand where the hotspots are,what scenarios give the greatest con-cern. It would allow us to ask superviso-ry questions. We’ll understand whichcounterparties or creditors are mostexposed to certain kinds of shocks andto whom they’re most exposed. A super-visory conversation that a regulatormight have with a large bank couldinclude the question, “Did you realizethat the hedge fund with which you

More About Darrell Duffie

Current PositionDean Witter Distinguished Professor of Finance, Graduate School ofBusiness, Stanford University; Coulter Family Faculty Fellow, 2011-12;on faculty since 1984

Professional Service

Member, Scientific Council, Duisenberg Institute, since 2010

Member, Scientific Committee, Swiss Finance Institute, since 2010

Member, Council, Society of Financial Econometrics, since 2009

Senior Fellow, Stanford Institute of Economic Policy Research, since 2009

Member, Squam Lake Working Group, since 2008

Member, Working Group on Global markets, Hoover Institution, since 2008

Member, Board of Directors, Pacific Institute of Mathematical Sciences,since 2007

Member of the Financial Advisory Roundtable, Federal Reserve Bank ofNew York, since 2006

Research Associate, National Bureau of Economic Research, since 1997

Honors and Awards

President, American Finance Association, 2009-10

Minerva Foundation Lecturer, Columbia University, 2011

Tinbergen Institute Finance Lecturer, Duisenberg Institute, 2010

Elected fellow, American Academy of Arts and Sciences, 2007

Clarendon Lecturer in Finance, Oxford University, 2004

Financial Engineer of the Year, International Association of FinancialEngineering, 2003

Distinguished Teacher, Doctoral Program, Graduate School of Business,Stanford University, 2003

NYSE Prize for Equity Research, Western Finance Association, 2002

Fellow and Member of the Council, Econometric Society, since 1997

Publications

Author of, among other books, Dark Markets, Princeton University Press,2012; Measuring Corporate Default Risk, Oxford University Press, 2011;How Big Banks Fail—And What to Do About It, Princeton University Press,2010; Dynamic Asset Pricing Theory, Princeton University Press, 3rd edi-tion, 2001. Published extensively in academic journals and elsewhere, withresearch on security markets, risk management, asset pricing theory andfinancial market innovation.

Education

Stanford University, Ph.D., engineering economic systems, 1984

University of New England (Australia), master of economics (economicstatistics), 1980

University of New Brunswick (Canada), B.S. in civil engineering, 1975

In the ideal world, we’d all be sitting at ourterminals watching for every possible pricedistortion. ... We’d all jump in like piranhas.... We’d drive out those price distortions andwe’d have very efficient markets. But in the

real world, you know, we all have otherthings to do, and we’re not payingattention. So we do rely on providersof immediacy, and we shouldexpect that prices are going to beinefficient in the short run andmore volatile.

have this large position also has largepositions in the same direction withseveral other large banks? Does thatgive you any concern about the liquidi-ty impact if this hedge fund had tounwind its position, and you and theother large banks in this asset classwould have to unwind or sell collateralassociated with that kind of a scenario?”

Of course, the information wouldneed to be treated very confidentially ata disaggregated level. But some of theinformation could be given to the pub-lic at a more aggregated level so that thepublic could also consider managing orrepricing these risks in a way that wouldimprove the health of the financial sys-tem. We wouldn’t want to panic anyone,though, by suddenly revealing that acertain financial institution had extremeexposures to some scenario.

Region: Essentially, this is sort of an“enhanced” stress test?

Duffie: It’s basically a network version ofa stress test. From private conversations,I think certain regulators are alreadydoing some of this.

At some point, we may hear moreabout what regulators are doing in thisarea. I’ve had many discussions aboutthis not only with U.S. regulators, but inthe United Kingdom, Switzerland andthe European Central Bank, among oth-ers. It’s much more effective if it’s doneon a global basis because, of course, thenetwork doesn’t stop at the boundariesof the United States.

SQUAM LAKE AND CAPITALREQUIREMENTS

Region: The Squam Lake report recom-mended setting high capital require-ments to mitigate risk of systemicallyimportant financial institutions. You’veechoed that recommendation in yourVolcker presentation and elsewhere inyour work. Two questions occur. First,how do you set the right level of capital?That is, what’s the right ratio of regula-

tory capital to assets? And second, howdo you know that firms won’t respondto higher capital requirements by actu-ally taking greater risks as they seekprofit on the remaining, nonregulatorycapital?

Duffie: The first question is by far theharder one, which is, “How much isenough?” And so far, I haven’t seen anyacademic or regulatory studies that havea strong conceptual foundation for say-ing 8 percent or 4 percent or 12 percentis enough. We know that, as measured,the capital requirements of large banksgoing into the last financial crisis weregenerally not enough. I think even thebanks would agree. While each individ-ual bank might say that it was fine,they’d also say that the banking systemin general was undercapitalized. Andcertainly that view of the Europeanbanking system currently prevails.

So “more” is an easier answer thancoming up with an exact figure for howmuch. The Basel III requirements unfor-tunately are going to be delayed, althoughbecause of the eurozone crisis, they’rebeing accelerated there somewhat. Butthey’re a step in the right direction.

I would err on the safe side. The Swiss

standard, which is roughly double thecapital requirements under Basel III, is agood example. One concern is that ifeach country were to set a standard onits own, then none would have sufficientincentive because banking mightmigrate to another banking center; therewould be a loss of competitiveness. Orpossibly even worse: a migration of badrisk or even an increase in risk. So itshould be done in a coordinated fashion.I think the Basel III process is a goodframework in which to do that.

The cost of getting it too high (with-in reasonable ranges) is less, in my view,than the cost of getting it too low. Someof the banks have suggested that raisingcapital requirements would significantlyreduce the appetite for banks to makeloans and provide other banking servic-es. I haven’t seen any strong research tojustify that view.

It would likely harm the position ofthe shareholders of those banks becausethey benefit from leverage. That’s a well-understood idea. They have an optionto take gains, but if things get badenough, they have no further lossesbecause of their limited liability. Soshareholders would suffer with highercapital requirements. But I am not con-

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The financial crisis caught almost all ofus unaware, and I am including myself.We weren’t, I think, looking broadlyenough for weaknesses in the financialsystem. The financial crisis has alerted

us to the important connectionbetween asset market behavior,

banking and the macro-economy.

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vinced that banking activities would bereduced dramatically by higher capitalrequirements. Basel III is certainly notoverly aggressive in my view.

Region: And how do you know that firmswon’t respond to higher capital require-ments by taking greater risk with nonreg-ulatory capital?

Duffie: I don’t believe, by the way, in theidea that capital should be just grossassets times some fraction. I think you dowant to have risk weights. After all,derivatives, for example, require almostno investment in assets, but they canhave a tremendous amount of risk perdollar up front. So I think you do need totune the capital to the type of risk that’staken. If that’s done in a judicious way,the opportunity to try to make up withextra risk for additional pressure to cre-ate returns for investors, I think, will beforestalled. The risk weights are veryimportant. And I would point not only tothe capital but also particularly to the liq-uidity, which in all of the discussions wehad earlier was a key element. It isn’t justwhether you are solvent. It is alsowhether you are able to get enough cashon short notice to meet your obligations,say, overnight.

“IGNORANCE IS BLISS”?

Region: In his recent presidential addressto the Econometric Society, BengtHolmstrom suggested that there may bea certain level of desirable opacity infinancial markets, that in some situationsa lack of complete transparency is vitalfor liquidity.Given your research on information

transmission in financial markets andthe effect of search and investor inatten-tiveness on asset pricing, what are yourthoughts about this idea?

Duffie: Well, as Bengt, my friend, himselfpoints out, that is true only so long as thequality of the opaque asset is not brought

into question. So, for example, with a col-lateralized debt obligation, as long asthere are no concerns, it’s wonderful thatinvestors who rely on these for collateralor as a source of risk taking in return fora yield—as long as they don’t becomeconcerned about the quality of thoseassets, they won’t need to invest time inunderstanding the incredibly complicat-ed prospectuses of these collateralizeddebt obligation deals.

I’ve actually examined them for someresearch with Nicolae Gârleanu—theyare really hard to sort out. It would beunfortunate if investors, each individual-ly, had to try to figure them out in orderto judge whether there were problems inthem. Ideally, that’s why investors dele-gated the monitoring of some of thesemore complex instruments to ratingagencies, but the rating agencies did notget this right either. I have been on theboard of directors of Moody’sCorporation since the month afterLehman failed. The market for relativelycomplex structured credit products hasnearly disappeared.

We do benefit from the opaqueness ofsome assets, but only so long as it is com-monly agreed that the asset is safe. But wecan get into a situation where all of a sud-den the quality of the asset is called intoquestion. And then we get extremeadverse selection; almost no one wants totouch the asset. What was your friendwhen you viewed the asset as safe is nowyour enemy and possibly becomes asource of market illiquidity. That’s exactlywhat led to the TARP legislation inCongress. The original idea of that TARPdeal, despite its ultimate application, wasto get around the opacity of some of thesecomplicated assets by having the govern-ment buy them and absorb the risk.

ASSET PRICES ANDCAPITAL FLOWS

Region: In your presidential address tothe American Finance Association, you

examined different impediments to capi-tal flow and their effect on asset prices.You look at search frictions (such asthose due to market opaqueness) andlimits on intermediation (like inventoryimbalances, including those during therecent crisis), and then you focus oninvestor inattentiveness—including astriking Tiger Woods anecdote that Ihadn’t heard before.1

You’ve studied investor inattention forover 20 years, and in your address, youpoint out that it has substantial influenceon price dynamics by thinning markets.Would you briefly explain this effect, andtell us about the relative contributions ofeach of these factors—search frictions,limited intermediation and investor inat-tention—to price dynamics?

Duffie: Sure, and these ideas also intersectwith what we discussed earlier, withrespect to the Volcker rule. The first real-ly interesting research in this area was byMerton Miller and Sandy Grossman, in1988 when they pointed out that not allinvestors are present and participating atall times in financial markets, buying andselling whatever assets others are bring-ing to the market. [See Grossman andMiller 1988.]

They pointed out that because of thatinattention by many investors, we rely onprofessional investors called marketmakers or liquidity providers to be thereand to absorb these sudden demands forimmediacy by those who feel they mustsell or must buy quickly. Of course, thesemarket makers and other liquidityproviders are not going to take the asso-ciated risk with almost no reward; they’regoing to require a price concession. Andthe fewer are the investors that are active-ly participating in a market on a givenday, the more the price concession wouldhave to be for liquidity providers toabsorb that risk.

We can imagine the sale of a largeblock of stock. Only a few professionalliquidity providers, such as market mak-ers, are there to absorb the block onto

25 JUNE 2012

their balance sheets. Everyone else is toosmall to take much, or is not payingattention on that day. The liquidityproviders will each have to take a largefraction of that large block. So investorinattention means large price conces-sions for large blocks of stock or otherassets, such as corporate bonds orTreasuries. Market makers will eventu-ally lay off these positions over time at aprofit to themselves.

The greater the inattention of the ordi-nary investor, the greater are these swingsin prices caused by price concessions attimes of liquidity shocks of this type, andthe greater are the resulting long-termreversals in price over time. I’ve beenlooking at this issue for some time.

After Miller and Grossman, probablythe next milestone in this literature is apaper by Markus Brunnermeier andLasse Pedersen in which they describewhat they called market liquidity andfunding liquidity. [See Brunnermeierand Pedersen 2008.] They made that dis-tinction because the ability of marketmakers to obtain financing for them-selves, their funding liquidity, will deter-mine in part the market liquidity ofassets. If market makers are not well cap-italized or have small risk limits orbecause regulations such as the Volckerrule are not able to absorb large chunksof risk on short notice, then the liquidityof the corresponding assets will be less.

In the ideal world, we’d all be sittingat our terminals watching for every pos-sible price distortion caused bydemands for immediacy. We’d all jumpin like piranhas to grab that, we’d driveout those price distortions and we’d havevery efficient markets. But in the realworld, you know, we all have otherthings to do, whether it’s teaching orinterviewing economists or whatever,and we’re not paying attention.

So we do rely on providers of imme-diacy, and we should expect that pricesare going to be inefficient in the shortrun and more volatile than they wouldbe in a perfectly efficient market, but in

a natural way. I have been studying mar-kets displaying that kind of price behav-ior to determine in part how much inat-tention there is or how much search isnecessary to find a suitable counterpar-ty for your trade.

FINANCE AND MACRO

Region: Let me ask you about financeand macroeconomics. The recent crisishas certainly brought greater promi-nence to financial economics. But fordecades, up until the 1960s perhaps,financial economics was given littlerecognition in macroeconomic theory.The Nobel awards first honored it in1990 with the prize to Markowitz,Miller and Sharpe. And in 1997, toMerton and Scholes.

But after the crisis, is enough beingdone to integrate financial economics intobroader macroeconomic scholarship?

Duffie: Well, I would say it’s by far thelargest growth area in Ph.D. disserta-tions that I’ve seen in a long time.

Region: And not just at Stanford?

Duffie: No, not just here. Prior to thefinancial crisis, there was a surge ofinterest in finance in areas like corporategovernance, compensation, behavioralfinance and many other important areas.But the financial crisis caught almost allof us unaware, and I am includingmyself. We weren’t, I think, lookingbroadly enough for weaknesses in thefinancial system. The financial crisis hasalerted us to the important connectionbetween asset market behavior, bankingand the macroeconomy.

The importance of mechanisms likecollateral for loans, for example. That’sprobably one of the most frequentlyresearched topics now for Ph.D. stu-dents in the general area of finance andmacro. Before the financial crisis, thetopic was almost exotic. So definitelythe agenda has changed. The integration

of macro and finance has been a bigimprovement in my view.

Region: Thank you very much.

Duffie: It’s been a great pleasure.

—Douglas ClementMarch 7, 2012

R

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Endnote1 In his American Finance Association presidential address, Duffierefers to a Wall Street Journal article (Feb. 19, 2010) that reported,“Investors took time out from trading to watch [Tiger] Woodsapologize for his marital infidelity. … New York Stock Exchangevolume fell to about 1 million shares, the lowest level of the dayat the time in the minute Woods began a televised speech. …Trading shot to about 6 million when the speech ended.”(Patterson, Michael, and Eric Martin, 2010, Wall Street takes breakfor Tiger Woods’ apology: Chart of day, Bloomberg)

References

Baily, Martin N., John Y. Campbell, John H. Cochrane, DouglasW. Diamond, Darrell Duffie, Kenneth R. French, Anil K. Kashyap,Frederic S. Mishkin, David S. Scharfstein, Robert J. Shiller,Matthew J. Slaughter, Hyun Song Shin, Jeremy C. Stein and ReneM. Stulz. 2011. Reforming Money Market Funds. Tuck School ofBusiness Working Paper 2011-86; Rock Center for CorporateGovernance at Stanford University Working Paper 109; ColumbiaBusiness School Research Paper 12-13. Available at SSRN:http://ssrn.com/abstract=1740663 orhttp://dx.doi.org/10.2139/ssrn.1740663.

Brunnermeier, Markus K., and Lasse Heje Pedersen. 2008. MarketLiquidity and Funding Liquidity. Oxford University Press onbehalf of the Society for Financial Studies. Available athttp://pages.stern.nyu.edu/~lpederse/papers/Mkt_Fun_Liquidity.pdf

Duffie, Darrell. 2012. Replumbing Our Financial System.Presented at Central Banking: Before, During and After the Crisis,a conference of the Board of Governors of the Federal ReserveSystem, March 23-24, Washington, D.C. Available at http://www.federalreserve.gov/newsevents/conferences/central-banking-conference-before-during-after-crisis-program.htm.

Grossman, Sanford, and Merton Miller. 1988. Liquidity andMarket Structure. Journal of Finance 43 (3): 617-33.

GlossaryBasel IIIThe Basel III accords are international regulatory standardsadopted in 2010-11 by members of the Basel Committee onBanking Supervision. The standards focus on capitalrequirements, stress testing and liquidity risk, and areintended to improve the banking sector’s ability to absorbshocks, improve risk management and increase transparen-cy. The reforms target both bank-level regulation and sys-temwide risk.

Central clearing counterparty (CCP)The Dodd-Frank Act requires that standard derivatives trad-ed by major market participants be cleared through a regulat-ed CCP that will stand between counterparties trading over-the-counter derivatives. (“Over-the-counter” refers to securi-ties transactions through broker-dealer networks, rather thanlarge exchanges like the New York Stock Exchange or Nasdaq.A derivative is a financial instrument in which value is basedindirectly on other assets, like commodity futures, stockoptions and risk swaps. It’s basically a contract between buyerand seller that specifies payment terms based on the underly-ing asset’s value at a specific date.)

The idea of a CCP is to buffer each counterparty againstpotential default by the other, thereby mitigating systemicrisk due to one default propagating subsequent defaults.CCPs might also increase transaction efficiency.

Collateralized debt obligationCDOs are investor securities backed by a pool of loans,bonds or other assets. Like other asset-backed securities,they are usually divided into “tranches,” or subsections, bymaturity date and risk level, with riskier tranches payinghigher rates of return. While CDOs were initially promotedas a means of reducing risk through diversification, manyanalysts suggest that their complexity and lack of regulatoryoversight instead raised systemic risk. CDO volumeincreased dramatically in the early 2000s, but the marketcollapsed during the recent financial crisis.

Credit default swap (CDS)A CDS is essentially an insurance contract that allows abuyer and seller to trade risk. It compensates the buyer

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against losses in the event of a loan default or othercredit event. The seller profits by charging a premiumfor such protection.

For example, a CDS would be an agreement betweenparties A and B regarding the potential default of companyC. (Although recent CDS news has involved potentialdefault on the sovereign debt of nations, rather than com-panies.) Party A wants insurance against C’s default—per-haps it has invested in C—and is willing to pay party B astream of payments, similar to paying insurance premiums,for that insurance. If C does default, B will pay a specifiedamount to A. If C doesn’t default, however, B retains theCDS payment stream, just as a health insurance companywouldn’t return premiums to a healthy customer.

Mark to marketMark to market is setting the price of an asset or liability toreflect current market valuation, rather than historical bookvalue. Often referred to as “fair value” accounting, markingto market seeks to provide an accurate picture of existing(or recent) market conditions, in contrast to cost account-ing based on transactions from the more distant past; bookvalue established through cost accounting may prove inac-curate if asset values change quickly and significantly. Thus,marking to market may provide greater real-time accuracy(assuming relevant markets are transparent and prices read-ily accessible), particularly during financial crises.

MetricsThe proposed rules for implementation of the Volcker ruleprovide a set of metrics (or measures) that would enableregulators to evaluate whether banks are in compliance withthe Volcker rule. Further, the rules would enact sanctionsfor significant increases in risk associated with market mak-ing or significant profits due to changes in price (as opposedto profits due to revenues from bid-to-ask price spreads,which are permitted by the Volcker rule).

These regulatory metrics are technical measures of fac-tors such as bank risk and revenue-to-risk ratios, includ-ing Risk and Position Limits, Value at Risk (VaR), StressVaR and Risk Factor Sensitivities. VaR, as one example,measures statistically the adverse impact that potential

changes in market rates and prices could have on a bank’sportfolio value.

Proprietary tradingProprietary trading is a term used to describe a bank orother financial institution seeking profit through specula-tive trading with its own funds rather than by earning com-missions through processing trades for its clients. TheVolcker rule would prohibit this proprietary tradingbecause it may encourage undue risk taking by financialinstitutions that are insured explicitly or implicitly by gov-ernment, and thereby raise systemic risk. The rule does,however, permit certain exceptions to this prohibition,including those related to “market making”—that is, tradingto provide asset immediacy or liquidity to facilitate investoractivity.

RepoShort for (sale and) repurchase agreement, a repo is a con-tract that combines the sale of a security with an agreementto repurchase the same security at a specified price at theend of the contract period. Effectively, it’s a secured or col-lateralized loan—a loan of cash against a security offered ascollateral.

“Tri-party repo” is a form of repo in which a thirdparty—a clearing bank—provides clearing and settlementservices to the cash investor and collateral provider. If theinvestor and provider instead engage directly with oneanother, rather than through a clearing bank, it is called a“bilateral repo.” In the 2000s, the tri-party repo marketbecame the primary funding source for securities dealers.During the financial crisis, the tri-party repo market expe-rienced little change in “haircuts,” or percentage discountsbetween cash deposit and security collateral; by contrast,haircuts increased dramatically in the bilateral repo market.